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Central Banks Scale Back Cash Injections

By

David Wessel and

Joellen Perry

Updated Aug. 14, 2007 12:01 a.m. ET

As strains in financial markets eased yesterday, the Federal Reserve, the European Central Bank and the Bank of Japan breathed sighs of relief and scaled back their injections of cash into money markets. But they said they remain poised to act again if necessary.

"Money-market conditions are normalizing and...the supply of aggregate liquidity is ample," said the ECB, which has been the most aggressive of the major central banks in trying to keep short-term market interest rates from rising above its target.

The Fed made only a modest $2 billion injection, well below Friday's $38 billion, and sought to convey a return to normalcy by intervening at its usual time, 9:30 a.m. Eastern time, instead of earlier as it did last week. The New York Federal Reserve Bank said it "stands ready to conduct additional operations." The Bank of England continued to be conspicuous by its absence.

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The Fed and the ECB -- playing the traditional role of central banks as lenders of last resort -- have been responding to an apparent shortage of lendable funds in their markets, exacerbated in part by a widespread reluctance to accept mortgage-backed securities as collateral in the wake of rising defaults on home loans. The spread of complex, hard-to-value securities has complicated matters, increased uncertainty and threatened to make it hard to borrow against good collateral.

But central bankers are trying to avoid the impression that they are fighting to stem the recent decline in the prices of stocks, bonds, mortgage-backed securities or other risky assets, or what they term "an increase in the price of risk." Central bankers for some time have voiced concerns that investors were taking too many risks without sufficient reward; as a result, they view some of the recent market moves as welcome.

If markets calm, the focus will shift to whether the past week has so dampened the outlook for the U.S., European and Japanese economies that monetary policy has to change -- meaning an interest-rate cut in the U.S. or a delay in expected rate increases in Europe and Japan.

Fed officials know that the "downside risks" to their forecast for "modest growth" are greater now than they were when the Fed met Aug. 7 and decided to keep interest rates unchanged. The housing industry's prospects have grown a bit dimmer, and there are unwelcome signs that jumbo mortgages -- those for more than $417,000 -- are harder to get and more expensive. But other data, such as July's retail sales figures, are encouraging.

Before joining the Fed, Chairman Ben Bernanke and a collaborator, Mark Gertler of New York University, argued in a widely noted academic paper that central banks shouldn't respond directly to changes in stock, bond and other asset markets, but rather should respond only when moves in asset markets threaten to affect the overall economy. Fed officials now are watching to see whether the credit crisis spreads beyond hedge funds and investors in mortgage-backed securities to crimp business and household spending, which would suggest that the Fed's previous economic forecast is too optimistic.

About 8:30 a.m. Friday, Mr. Bernanke convened a conference call to brief the Fed governors in Washington and the presidents of the regional Fed banks. Around 9:15 a.m., the Fed, attempting to assure markets that it was on the job, issued a statement saying it was "providing liquidity to facilitate the orderly functioning of financial markets." According to people familiar with the call, no proposal to alter the Fed's interest-rate target was made or discussed. The Fed's next scheduled meeting is Sept. 18. Markets have been anticipating it might reduce rates before then.

When a central bank intervenes in markets, as the Fed has been doing, it executes agreements under which it trades cash for government debt and other high-grade securities for a set period of time. In an unusual move Friday, the New York Fed effectively encouraged the dealers through which it operates to submit high-grade mortgage-backed securities, those guaranteed by the Government National Mortgage Association, Fannie Mae and Freddie Mac.

Before the Fed acted, market prices suggested an unusual widening of the preference for conventional Treasury securities over high-grade mortgage-backed securities. The Fed maneuver effectively offset that and avoided adding to the already-intense demand for conventional Treasurys. The New York Fed's open-market operations didn't involve securities backed by loans to subprime borrowers -- those with poor credit -- or privately issued mortgage-backed securities.

Trading in European markets yesterday, meanwhile, suggested European banks are having trouble meeting obligations to deliver U.S. dollars. The ECB can supply unlimited amounts of euros, but not unlimited amounts of dollars. As a result, there has been market speculation that the ECB and Fed may swap euros for dollars to bolster the ECB's ammunition.

Yesterday, the ECB pumped &euro;47.67 billion ($65.29 billion) into its markets to keep rates from rising much above its 4% target. That was less than its massive one-day injection of &euro;95 billion Thursday and a three-day injection of &euro;61 billion on Friday to cover the weekend.

"Things seem to have calmed down a bit, and we've started out the week certainly far better than we ended it," said Neville Hill, an economist at Credit Suisse in London. "But it's a bit too soon to say we're out of the woods yet."

Asked about the vigor of the euro-zone economy in an interview with French newspaper Ouest France published Friday, ECB President Jean-Claude Trichet said, "The robust growth we diagnosed several months ago has been confirmed." Markets are no longer as certain as they were a week ago that the ECB will raise its rate target Sept. 6.

Central Banks Scale Back Cash Injections

As strains in financial markets eased yesterday, the Federal Reserve, the European Central Bank and the Bank of Japan breathed sighs of relief and scaled back their injections of cash into money markets.